History stole your investment returns

While reading Josh Brown’s book Backstage Wall Street last weekend, I came across this quote from current New York Times columnist Joe Nocera. It’s from 1995, when the Dow Jones index traded at around 4,000. Back then, Nocera couldn’t believe the optimism sweeping investors away:

The pessimists — PESSIMISTS! — say that the Dow will go to 5000 by the turn of the century, and that the fund industry will grow by an additional trillion dollars. The most optimistic — Jessica Bibliowicz of Smith Barney, as it happens — predicts a 6500 Dow.

Funny: By 2000, the Dow traded above 11,000. How many times in history have the most optimistic investors been off by 70% on the upside? As far as I know, never.

I won’t ramble on about how big the dot-com bubble was or how dumb investors were back then. That got old years ago.

But there’s a related point that’s still worth talking about. What’s interesting about the 1995 forecasts Nocera cites is how rational they were. Since the 1950s, the Dow has increased by an average of 6.8% a year (before dividends). With the Dow trading at 4,000 in 1995, the analysts polled in Nocera’s article were forecasting annual returns of 5% to 9% — normal, average returns, basically.

In other words, assuming valuations were reasonable in 1995 (and they were, for the most part), the Dow should have traded somewhere between 5,000 and 6,500 in 2000. That’s where you should have expected it to have been had there been no dot-com bubble.

Now, if the Dow had traded at 5,000-6,500 in 2000, think about what that would mean for investors today. Instead of the “lost decade” investors endured from 2000-2010, they would have earned an average annual return of 6% to 8.5% a year — almost exactly average, historically.

Here’s another way to think about this. The light line below is a hypothetical Dow increasing 6.8% a year (the historic average) starting in 1995. The dark line is the actual Dow:

Sources: S&P Capital IQ and author’s calculations.

Did you notice? The two lines end in the exact same spot. Returns from 1995 through today have been almost exactly average, historically.

And yet think of all the frustration over lousy market returns lately — disgruntled investors sullen over the fact that most money invested over the last decade has lost value after inflation. Without question, the last 10 or 12 years have been an awful time for most investors.

The takeaway from that is really important:

From 1995 through today, the Dow produced average returns of about 7% a year. That’s good.

But nearly all of those returns happened from 1995 to 2000. The market literally took 17 years’ worth of returns and squeezed them into five, which sent valuations in 2000 through the roof.

Valuations in 2000 practically guaranteed that returns over the last decade would be poor.

I know. You might think there’s a touch of the ‘Monday morning expert’ in me saying, “Look, if you invested in 1995 instead of 2000, you’d be rich today!”

But that’s exactly what I’m saying, and I think it needs to be repeated over and over again. For the literally tens of millions of pages of market analysis and financial advice out there, smart investing really boils down to just three points:

Buy stocks when they’re cheap, or at least reasonably valued. That doesn’t mean market timing; it means focusing on valuations above all else.

Hold them for a long time. That could mean a decade or more.

Ignore what happens in between. If you choose to watch, be assured: It will be ugly at times.

Anyone who bought from 1997-2000 or 2006-2007 when valuations were high and felt cheated two or three years later as returns sank broke all three rules. Many more will do so in the future. And just like over the last decade, they’ll sit in shocked disbelief, wondering what happened, when the honest answer is, “Nothing unusual.”

As Ben Graham, Warren Buffett’s early mentor, used to say, “In the short term, stocks are a voting machine, and in the long term, stocks are a weighing machine.”

During no time has that been more evident than 1995 through today on the Dow – and the lessons are just as true for Australian investors as our American cousins.

We’re always looking for undervalued stocks – and all the better when they have a good platform for growth. If you are looking for ASX investing ideas, look no further than “The Motley Fool’s Top Stock for 2012.” In this free report, Investment Analyst Dean Morel names his top pick for 2012…and beyond. Click here now to find out the name of this small but growing telecommunications company. But hurry – the report is free for only a limited period of time.

While reading Josh Brown’s book Backstage Wall Street last weekend, I came across this quote from current New York Times columnist Joe Nocera. It’s from 1995, when the Dow Jones index traded at around 4,000. Back then, Nocera couldn’t believe the optimism sweeping investors away:

The pessimists — PESSIMISTS! — say that the Dow will go to 5000 by the turn of the century, and that the fund industry will grow by an additional trillion dollars. The most optimistic — Jessica Bibliowicz of Smith Barney, as it happens — predicts a 6500 Dow.

Enter your email below for FREE access to this article and all the content on the site. Also receive Take Stock, The Motley Fool's unique daily email on what's really happening with the share market. You may unsubscribe any time.

We love you, but we need to talk. It's your browser. Internet Explorer 8 (or older) has known security flaws, and may not display all of our Foolish website's features – or those of other websites, for that matter. We encourage you to use the following link to update your browser so that you can more safely browse the Web (http://browsehappy.com/).